The family limited partnership (FLP) is a popular method for shifting wealth from one generation to another. Because of its misuse, however, the IRS has attacked the FLP, sometimes with successful results.
But before you categorize the FLP as an aggressive and illegal tax shelter, it’s important to understand that the IRS won in tax court only when taxpayers treated the FLP as an extension of themselves and used the partnership’s assets as their own.
If properly administered, the FLP remains a very useful planning tool. By reviewing recent tax court cases involving FLPs we can learn how to use an FLP correctly in estate planning.
But first, let’s clearly define our terms. What is a family limited partnership, anyway? A partnership is “an association of two or more persons to carry on, as co-owners, a business for profit.” To be treated as bona fide by the IRS, a partnership must have a substantive business purpose and observe partnership formalities. There are two types of partnerships: the general partnership and the limited partnership.
In a general partnership, there is no firewall between the partnership’s activities and the partners. In other words, partners are personally responsible for the business’s liabilities. In a limited partnership, there is at least one general partner and one limited partner. The general partner acts as the business’s manager and acts on behalf of all the other owners. The limited partner is a passive investor. While the general partner is personally liable for the debt of the partnership, the limited partner can only lose the assets he or she contributed.
In an FLP, the parents or grandparents create and transfer personally owned assets to the business. Typically, the FLP is funded with real estate, stock in a family-owned corporation, or publicly traded securities. Over time, the older generation will give or sell limited partnership units to the children or grandchildren. The goal is to reduce the older generation’s ownership to between 1% and 25% of the FLP.
The FLP is attractive because it provides an opportunity to substantially reduce gift taxes and the taxable estate through valuation discounts, while allowing the donors to retain some control over the partnership’s assets. As general partner, the older generation can transfer their wealth and, at the same time, manage and make all investment decisions for the younger generation.
Valuation discounts allow the estate owner to give away more tax-free using an FLP than by giving the underlying assets outright to the younger generation. When determining the fair market value of a limited partnership interest, it is common to take into account both lack-of-marketability and minority discounts of 15% to 45%. For example, rather than transferring $1.8 million in wealth to the next generation, through the creation of an FLP a parent could potentially reduce the gift to $1 million for tax purposes.
While the gift and estate tax benefits of an FLP are compelling, the FLP is not without disadvantages.
- It adds complexity and cost to the estate plan. Hard-to-value assets will need a professional appraisal at the time each partnership unit is transferred from one generation to the next.
- While the parents can manage the FLP, they cannot treat the partnership’s assets as if they still belong to them.
- The general partner retains unlimited liability. (In some states, the creation of a family LLC provides the advantages of an FLP without the liability exposure.)
- It increases the probability of an IRS audit.
Recently, there has been a flurry of challenged estate tax returns involving FLPs. An examination of recent court cases provides a road map for how not to use FLPs.
Abraham: Good Intentions Awry
This is a case where the family limited partnership was doomed by good intentions. One of the time-honored rules of estate planning is that a gift must be complete to be effective. Except in limited instances, if the donor continues to enjoy the fruits of the gift, it has not been removed from her estate. In this case, the Abraham family created the FLP to provide for the guaranteed support of the matriarch, Ida Abraham.
Ida Abraham inherited three pieces of commercial real estate from her husband. In 1993, she was diagnosed with Alzheimer’s and her daughter was appointed her guardian. Her other three children sued their sibling over the amount needed to care for Mrs. Abraham. The cost of litigation became so draining that the probate court stepped in and required that an estate plan be put into place to meet her needs.
The plan included three FLPs, each funded by a piece of commercial real estate. Mrs. Abraham became both a general and a limited partner in each FLP; however, due to her incompetency, an attorney was appointed her guardian ad litem to manage her interest in the partnerships. Her guardian was also the sole shareholder of the corporation that acted as a managing general partner. Three of her four children purchased limited partnership units in the respective
FLPs for nominal sums of money. They also received gifts of limited partnership units annually.
In approving this estate plan, the probate court decreed that Mrs. Abraham would never want for money, even if the shortfall had to come from the children’s partnership shares. While the partnership agreements did not require the partnership to support Mrs. Abraham, it was understood by all that the FLPs would guarantee protection of her status quo.
A few years later, Mrs. Abraham died and the IRS challenged the estate tax return. Unwittingly, the children’s own testimony about the purpose of the FLP sealed the IRS’s case against the estate.
The tax court found that there was no bona fide sale of FLP interests between Mrs. Abraham and the children because there was no attempt to substantiate the fair market value of the units and the applied discounts at the time of the transfer. The court also found that there was an implied agreement between Mrs. Abraham, her guardian ad litem, and her children that the FLPs were obligated to support Mrs. Abraham, even to the detriment of the other partners.
Mrs. Abraham’s estate was assessed $939,195 in additional estate taxes. (Estate of Ida Abraham et al. v. Commissioner; No. 04-1886; Abraham v. Commissioner, T.C. Memo 2004-39; February 18, 2004)
Korby: Only to Avoid Taxes
This is a recent case where the parents sought to eliminate estate taxes by stripping themselves of all their assets during their lifetimes–leaving nothing to pay their most basic living expenses. The IRS and the courts found that the FLP did not serve any purpose other than to discount the taxable value of the estate. All the FLP assets were included in Austin Korby’s taxable estate because the deceased retained enjoyment in the property until his death.
In 1994, an FLP named KPLP was formed by Mr. Korby and his wife, Edna, a nursing home resident at the time. The couple’s joint revocable trust was the only general partner. Austin and his wife funded the FLP with almost $2 million in cash, stocks, and bonds. After KPLP’s creation, the couple gifted about 98% of the partnership to irrevocable trusts for the benefit of each of their sons and took a 43.61% valuation discount on the gifts.
The living trust received unscheduled income payments from the FLP and paid all the couple’s basic living expenses and taxes. The sons received no distributions before their parents’ death.
Again the IRS challenged the Korby estate tax return. The Korby estate was found to be deficient $1,070,482 in estate taxes. The courts ruled that KPLP was created to transfer the Korby wealth at a reduced tax cost and had no other non-tax purpose. There was also evidence of an implied agreement between Korby and his sons to support Mr. and Mrs. Korby as long as they needed it. (Estate of Austin Korby et al. v. Commissioner; T.C. Memo. 2005-103; No. 18452-02)
Bigelow: Still Enjoying the Fruit
The Bigelow case also involves a taxpayer who impoverished herself in order to avoid estate taxes and yet continued to enjoy her transferred property.
Virginia Bigelow created a revocable trust in 1991, which held several mortgaged rental properties. Several years later, after she entered an assisted living facility, her revocable trust transferred its rental properties to a newly created FLP, but retained Mrs. Bigelow’s mortgages. The partnership made mortgage payments on behalf of Mrs. Bigelow’s revocable trust, the FLP’s only general partner. During the years before her death, Mrs. Bigelow reduced her remaining assets to almost nothing through gifts to her family and relied on the FLP’s payments to her trust to pay her living expenses.
When Mrs. Bigelow died in 1997, the estate claimed a 37% marketability discount for the 45% FLP interest owned by the trust. The IRS contested the estate tax return on the grounds that Mrs. Bigelow retained an interest in the FLP real estate when the FLP paid the mortgage obligation of the revocable trust. It did not go unnoticed by the court that Mrs. Bigelow died with no liquid assets to pay her basic living expenses and had to rely on income from the FLP. Consequently, the entire FLP was pulled back into her taxable estate. This case is expected to be appealed. (Estate of Virginia A. Bigelow; T.C. Memo 2005-65)
Bongard: Actions Speak Quite Loudly
This case is unlike the previous ones in that the donors did not depend on the FLP to sustain their lifestyle. Its lesson is that it is not good enough to document why you are creating an FLP. Your actions must speak as loud as your words.
Wayne Bongard’s estate plan for his closely held business, Empak, involved an interplay of irrevocable trusts, an LLC, and an FLP to provide a three-tier discount for estate tax purposes. Mr. Bongard controlled Empak as its CEO and only director. Empak shares were held by an LLC, which in turn was held by Mr. Bongard, the Bongard FLP, and various family trusts. The courts ruled that Mr. Bongard had a legitimate and significant non-tax business reason for creating the LLC, but not for the FLP.
When Mr. Bongard created his FLP in 1996, he sent a letter to his children outlining the reasons for creating the partnership. While he stated that the FLP would allow his family to share his wealth without giving them an incentive to avoid work, he never ended up giving away limited partnership interests to his children.
His stated intention of providing creditor protection was rejected because the LLC shares already provided that creditor protection. Mr. Bongard’s contention that the FLP provided his estate with greater flexibility compared to trusts was also dismissed since he created several family trusts shortly after setting up the FLP. Finally, Mr. Bongard’s letter said that the FLP would teach the children how to manage the family assets. The courts found that the FLP provided no further diversification or asset management of the LLC shares it held.
While Mr. Bongard may have documented his reasons for creating the partnership, his actions did not support his letter. For this and other reasons, the tax court returned $96 million back into Mr. Bongard’s taxable estate. (Estate of Bongard v. Commissioner, No. 6141-03; 2005 WL 590670; March 15, 2005)
It is worth noting that the IRS has recently suffered a string of losses in its challenge of FLPs. With good communication to all family members and an attention to detail, the FLP continues to be a useful estate planning tool. That brings up an obvious question:
When Is an FLP Appropriate?
An FLP is appropriate when the family wants one business entity to manage the family’s wealth and when the non-managing owners of the business want limited liability for the obligations of the partnership. It is also effective when the family is concerned about the next generation’s exposure to creditors or to a failed marriage.
A family limited partnership is also recommended when the family wants centralized management of family wealth to continue after the death of the older generation. While an irrevocable trust can provide centralized management and creditor protection, the donor cannot act as trustee; the older generation must completely step away from the trust in order for it to be an effective estate transfer tool. In a family partnership or an LLC, the older generation can act as the managing partners and thus control the partnership’s investment decisions.
Tere D’Amato, CLU, ChFC, and CFP, is director of advanced planning, wealth management, for Commonwealth Financial Network in Waltham, Massachusetts, managing Commonwealth’s planning efforts across its spectrum of wealth management services. D’Amato earned her MSFS with an emphasis on estate planning through the American College in 2003. She can be reached at email@example.com.